When an investment declines in value after purchase, it’s generally considered a bad thing. For investors who know their tax rules, however, capital losses have a silver lining. Each year, the IRS lets you use investment losses to offset an unlimited amount of capital gains and up to $3,000 of ordinary income. By strategically harvesting capital losses instead of simply absorbing them, opportunistic investors can soften the blow of declining investments and boost their long-term returns.

The Basics of Tax Loss Harvesting

Tax loss harvesting is simply the practice of selling securities at a loss in order to offset a tax liability. Let’s say that you bought $8,000 of Vanguard’s Total Stock Market Index Fund (VTSMX) in a taxable investment account last month. Today, it’s worth only $7,000. By selling the fund and realizing a $1,000 loss, you can offset capital gains from other securities or, if you don’t have other capital gains, reduce your 2010 taxable income by $1,000. For those in the 25% federal tax bracket, that represents a $250 savings at tax time. You can use up to $3,000 per year to offset tax liabilities, and if your net capital losses add up to more than $3,000, you can carry them over to future tax years. While many investors wait until the end of the year to harvest their losses, there’s no reason why you can’t scan your portfolio for tax loss harvesting opportunities throughout the year.

The Wash Sale Rule

Ok, so you may be wondering, “What if VTSMX was part of my strategic allocation? Can I buy it back?” Well, not exactly. The IRS created the Wash Sale Rule to discourage investors from making trades solely for tax purposes. This rule prevents you from claiming a capital loss if you buy a “substantially identical” security within 30 days (before or after) the sale that triggered the loss. In other words, to restore your market position after the sale, you’ll have to either 1) wait 31 days to repurchase VTSMX or 2) find a similar, but not “substantially identical” replacement fund. If you violate the Wash Sale Rule, you won’t be able to claim the capital loss on your tax return.

The IRS doesn’t provide a clear definition of a “substantially identical” security, but in my opinion, a replacement investment needs to change your position relative to the market. In other words, if you’re going to harvest losses from an index fund or ETF, be sure to pick a replacement fund that tracks a different index. A suitable replacement fund for VTSMX would be Vanguard’s Large-Cap Index Fund (VLACX). This fund tracks a different index than VTSMX, but its pattern of returns is similar. VTI, Vanguard’s Total Stock Market ETF, would not be a suitable replacement for VTSMX, as these two funds track the same index and share the same holdings. It should be noted that the rapid growth of the ETF marketplace has made life much easier for tax loss harvesters. ETFs that represent core asset classes typically have at least one, if not several, low-cost substitutes.

A Few Things to Watch Out For

You can put yourself at risk of unknowingly violating the Wash Sale Rule by electing to automatically reinvest dividends in a taxable account. Dividends and capital gains distributions can trickle in for several months after you’ve sold a security, potentially nullifying your capital loss claim. For the same reason, you shouldn’t try to harvest losses on a fund that you also own in an IRA.

Additionally, don’t forget to consider all costs and fees when making decisions about harvesting losses. Trading commissions and redemption fees can quickly offset the financial benefits of tax loss harvesting, and for many investors, the additional time required to research harvesting opportunities and make the appropriate trades isn’t worth the potential long-term gain. Tax loss harvesting is an advanced strategy with several factors to consider, so if you’re not sure whether it makes sense for you, it’s probably best to steer clear or consult a tax advisor.

Finally, it’s important to keep strategies like tax loss harvesting in perspective. While opportunities to harvest losses can reap substantial rewards, especially for investors in higher tax brackets, your long-term investment returns will be driven primarily by your ability to develop and maintain a risk-appropriate asset allocation plan. That being said, if you can maintain a long-term perspective while staying poised to take advantage of tax loss harvesting opportunities as they present themselves, you can convert disappointing capital losses into valuable long-term returns.